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Ri = i + i Rm +ei
Ri expected return on security i
i intercept of the straight line or alpha co efficient
i slope of straight line or beta co efficient
Rm the rate of return on market index
Ei error term
Ri = i + iRm + ei
The variance of securitys return, 2 = i 2m + 2ei
Covariance of returns securities i and j is
ij = i j + 2m
The variance of the security has two components namely, systematic risk or
market risk and unsystematic risk or unique risk. The variance explained by
the index is referred to systematic risk. The unexplained variance is called
residual variance or unsystematic risk.
Systematic risk = 2i x variance of market index.
= 2 i 2 m .
Unsystematic risk = Total variance Systematic risk.
e2i = 2i systematic risk
Thus, the total risk = Systematic + Unsystematic risk.
From this the portfolio variance can be derived.
N N
2p = (xi i )2 2m + x2i e2i
i=1 i=1
2p = variance of portfolio
N
Rp = xi ( i + i Rm)
i=1
N
p = x
i=1 i i
Rp
R B
2
6
9
14
15
A
0 p
S
SHARPES OPTIMAL PORTFOLIO
Sharpe had provided a model for the selection of
appropriate securities in a portfolio. The selection of
any stock is directly related to its excess return beta
ratio.
Ri - Rf
i
Where,
Ri = the expected return on stock i
Rf = the return on a riskless asset
i = the expected change in the return on stock i
associated with one unit change in the market return
The steps for finding out the stocks to be included
in the optimal portfolio are given below :
1. Find out the excess return to beta ratio for each
stock under consideration.
2. Rank them from the highest to the lowest.
3. Proceed to calculate Ci for all the stocks according
to the ranked order using the following formula.
N (Ri Rf )i
m
2
2ei
i=1
Ci =
N i2
1+2m i = 1 ei
2
ip (Rp Rf )
Ci =
i
ip the expected change in the rate of return on stock I
associated with 1 per cent change in the return on the
portfolio.
Rp the expected return on the optimal portfolio
Ri Rf
> Ci
i
The above equation can be rearranged with the substitution of equation :
ip (Rp Rf )
Ci =
i
Now we have,
Ri Rf > ip (Rp Rf )
OPTIMUM PORTFOLIO WITH SHORT SALES
Zi
Xi = N
Zi
i=1
i Ri Rf
Zi = 2 C
ei i
CONCLUSION :